This Isn’t Good for the Markets

Participants in the markets yawned when the Federal Reserve recently announced it will reduce its monthly bond buying from$45 billion to $35 billion. It was widely telegraphed, and therefore had little effect.

What did capture people’s attention is Chairman Yellen’s hedging comments about how long short-term interest rates will remain at historic lows. With the overnight Fed funds rate sitting at 0% to 0.25%, we’re at the bottom.

For the past six months, analysts have forecast that the Fed will begin raising interest rates within six months of the end of its bond buying. Given that the bond buying is being reduced by $10 billion at each meeting, the end of the program should occur this fall.

That would mean we’re looking at higher interest rates at the end of the first quarter of 2015.

But during her recent press conference, Ms. Yellen seemed to step away from such a commitment…

She noted that the consensus of the board was that rates would be above 1% by the end of 2015. However, she also noted that they would rely on current economic data to make the final determination.

Markets and Interest Rates

This sounds a lot like the Fed’s statement that it would stop interfering with the markets when unemployment fell to 6.5%, but then they backtracked as the unemployment rate got close to that number.

Even though unemployment has fallen, economic prosperity has not returned. So the Fed wants to keep the punch bowl at the party for a while longer.

Yes, it has been reducing its bond buying, but the effectiveness of that program, beyond the first efforts, has been questionable, particularly since the extra funds are not flowing into the economy as credit… instead, sitting right back at the Federal Reserve in the form of excess reserve deposits from banks.

Which brings us back to interest rates.

While bond buying might not make much difference to a lot of people, lower interest rates certainly do, even if those people are not borrowers.

The view that low interest rates only helps home buyers or consumer-related debt is not true. Corporations are making out like bandits.

Recently, Apple was able to issue $2 billion worth of two-year bonds, paying 2.1%. The company issued $1.5 billion worth of three-year bonds, paying 1.05%. It also issued five-year, 10-year, and 30-year bonds, for a total of $12 billion, all at exceptionally low rates of interest.

This might seem odd for a company that has $151 billion in the bank… but it makes sense when you look at the bigger picture.

Apple has more than $130 billion overseas. To bring that money home, the company would have to pay taxes, which sounds like no fun at all. Instead, the company can borrow money in the U.S. and write off the interest as an expense, which lowers its effective interest rate on the debt even further.

At this point, the money is almost free, mostly because of the low interest rates the Fed put in place.

Then the money finds its way into the equity markets through the magic of stock buybacks, which are all the rage in the S&P 500.

In the first quarter of 2014, stock buybacks among the S&P 500 companies increased 59% from the same quarter a year ago, totaling $159.3 billion. This amount was only exceeded by the amount of stock buybacks in the third quarter of 2007, the top of the market before the financial crisis.

By one estimate, stock buybacks boosted earnings per share by 4% or more on 99 of the companies in the S&P 500, simply by lowering the number of shares outstanding.

The leader of the pack was Apple, which spent $18 billion on its own shares, trimming its diluted shares by 7.1%, and improving earnings per share by 15.2%.

That’s quite a gift to shareholders, all courtesy of the Fed.

Incidentally, some of this came at the expense of the U.S. Treasury, which didn’t share in any tax revenue from funds brought to the U.S. from overseas.

In fact, the U.S. Treasury actually lost revenue because Apple, along with others, chose to issue debt and therefore had higher expenses in the form of interest, giving the company lower taxable profits in the U.S.

What should be done with overseas profits is a different topic. The main point here is that very low interest rates are fueling a frenzy of stock buybacks that are being funded with debt, which is driving earnings per share and the equity markets higher.

Unfortunately, at the end of the day, companies using this tactic are simply trading debt on their balance sheet for shares outstanding. So while remaining stockholders have experienced a move up, the companies they own are more leveraged than they were before.

This is not a game that can go on forever. Companies that shrink their float, as it’s called, can boost their stock price for a little while, but it’s a game of musical chairs. Eventually, these companies need to grow, increasing their revenue and their profits, not just retire outstanding shares.

The key for investors is to enjoy the trend as long as it continues, but make sure you have a plan in place, like following our Boom & Bust model portfolio and Adam O’Dell’s Cycle 9 Alert service, for when the music stops.

Rodney

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Categories: Bonds

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.